1. Financial integration and short-run macroeconomic equilibrium
Chap in the Krugman and Obstfeld textbook
Chap. 22, 23, 24, 25 in the Mishkin textbook
Large capital flows today -> open economies
Consequences of these capital flows on short-run macroeconomic equilibrium
Copyright © 2003 Pearson Education, Inc.

2. Chapter Organization
Determinants of Aggregate Demand in an Open Economy
The Equation of Aggregate Demand
How Output Is Determined in the Short Run
Output Market Equilibrium in the Sort Run: The DD Schedule
Asset Market Equilibrium in the Short Run: The AA Schedule
Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
Copyright © 2003 Pearson Education, Inc.

3. Chapter Organization Temporary Changes in Monetary and Fiscal Policy
Inflation Bias and Other Problems of Policy Formulation
Permanent Shifts in Monetary and Fiscal Policy
Macroeconomic Policies and the Current Account
Gradual Trade Flow Adjustment and Current Account Dynamics
Summary
Copyright © 2003 Pearson Education, Inc.

4. Introduction
Macroeconomic changes that affect exchange rates, interest rates, and price levels may also affect output.
This chapter introduces a new theory of how the output market adjusts to demand changes when product prices are themselves slow to adjust.
A short-run model of the output market in an open economy will be utilized to analyze:
The effects of macroeconomic policy tools on output and the current account
The use of macroeconomic policy tools to maintain full employment
Copyright © 2003 Pearson Education, Inc.

5. Determinants of Aggregate Demand in an Open Economy
The amount of a country’s goods and services demanded by households and firms throughout the world.
The aggregate demand for an open economy’s output consists of four components:
Consumption demand (C)
Investment demand (I)
Government demand (G)
Current account (CA)
Copyright © 2003 Pearson Education, Inc.

6. Determinants of Aggregate Demand in an Open Economy
Determinants of Consumption Demand
Consumption demand increases as disposable income (i.e., national income less taxes) increases at the aggregate level.
The increase in consumption demand is less than the increase in the disposable income because part of the income increase is saved.
Copyright © 2003 Pearson Education, Inc.

7. Determinants of Aggregate Demand in an Open Economy
Determinants of the Current Account
The CA balance is viewed as the demand for a country’s exports (EX) less that country's own demand for imports (IM).
The CA balance is determined by two main factors:
The domestic currency’s real exchange rate against foreign currency (q = EP*/P)
Domestic disposable income (Yd)
Copyright © 2003 Pearson Education, Inc.

8. Determinants of Aggregate Demand in an Open Economy
How Real Exchange Rate Changes Affect the Current Account
An increase in q raises EX and improves the domestic country’s CA.
Each unit of domestic output now purchases fewer units of foreign output, therefore, foreign will demand more exports.
An increase q can raise or lower IM and has an ambiguous effect on CA.
IM denotes the value of imports measured in terms of domestic output.
Copyright © 2003 Pearson Education, Inc.

9. Determinants of Aggregate Demand in an Open Economy
There are two effects of a real exchange rate:
Volume effect
The effect of consumer spending shifts on export and import quantities
Value effect
It changes the domestic output worth of a given volume of foreign imports.
Whether the CA improves or worsens depends on which effect of a real exchange rate change is dominant.
We assume that the volume effect of a real exchange rate change always outweighs the value effect.
Copyright © 2003 Pearson Education, Inc.

10. Determinants of Aggregate Demand in an Open Economy
How Disposable Income Changes Affect the Current Account
An increase in disposable income (Yd) worsens the CA.
A rise in Yd causes domestic consumers to increase their spending on all goods.
Copyright © 2003 Pearson Education, Inc.

11. Determinants of Aggregate Demand in an Open Economy
Table 16-1: Factors Determining the Current Account
Copyright © 2003 Pearson Education, Inc.

12. The Equation of Aggregate Demand
The four components of aggregate demand are combined to get the total aggregate demand:
D = C(Y – T) + I + G + CA(EP*/P, Y – T)
This equation shows that aggregate demand for home output can be written as:
D = D(EP*/P, Y – T, I, G)
Copyright © 2003 Pearson Education, Inc.

13. The Equation of Aggregate Demand
The Real Exchange Rate and Aggregate Demand
An increase in q raises CA and D.
It makes domestic goods and services cheaper relative to foreign goods and services.
It shifts both domestic and foreign spending from foreign goods to domestic goods.
A real depreciation of the home currency raises aggregate demand for home output.
A real appreciation lowers aggregate demand for home output.
Copyright © 2003 Pearson Education, Inc.

14. The Equation of Aggregate Demand
Real Income and Aggregate Demand
A rise in domestic real income raises aggregate demand for home output.
A fall in domestic real income lowers aggregate demand for home output.
Copyright © 2003 Pearson Education, Inc.

15. The Equation of Aggregate Demand
Figure 16-1: Aggregate Demand as a Function of Output
Output (real income), Y
Aggregate
demand, D
Aggregate demand function,
D(EP*/P, Y – T, I, G)
45°
Copyright © 2003 Pearson Education, Inc.

16. How Output Is Determined in the Short Run
Output market is in equilibrium in the short-run when real output, Y, equals the aggregate demand for domestic output:
Y = D(EP*/P, Y – T, I, G) (16-1)
Copyright © 2003 Pearson Education, Inc.

17. How Output Is Determined in the Short Run
Figure 16-2: The Determination of Output in the Short Run
Output, Y
Aggregate
demand, D
Aggregate demand =
aggregate output, D = Y
Aggregate demand 3 Y3 D1 1 Y1 2 Y2
45°
Copyright © 2003 Pearson Education, Inc.

18. Output Market Equilibrium in the Short Run: The DD Schedule
Output, the Exchange Rate, and Output Market Equilibrium
With fixed price levels at home and abroad, a rise in the nominal exchange rate makes foreign goods and services more expensive relative to domestic goods and services.
Any rise in q will cause an upward shift in the aggregate demand function and an expansion of output.
Any fall in q will cause output to contract.
Copyright © 2003 Pearson Education, Inc.

19. Output Market Equilibrium in the Short Run: The DD Schedule
Figure 16-3: Output Effect of a Currency Depreciation with Fixed Output Prices
Output, Y
Aggregate
demand, D
D = Y
Aggregate demand (E2)
Currency
depreciates Y2 2
Aggregate demand (E1) 1 Y1
45°
Copyright © 2003 Pearson Education, Inc.

20. Output Market Equilibrium in the Short Run: The DD Schedule
Deriving the DD Schedule
DD schedule
It shows all combinations of output and the exchange rate for which the output market is in short-run equilibrium (aggregate demand = aggregate output).
It slopes upward because a rise in the exchange rate causes output to rise.
Copyright © 2003 Pearson Education, Inc.

21. Output Market Equilibrium in the Short Run: The DD Schedule
Figure 16-4: Deriving the DD Schedule
Output, Y
Aggregate demand, D
D = Y
Aggregate demand (E2)
Aggregate demand (E1) Y2 Y1 Y1 Y2
Output, Y
Exchange rate, E DD E2 2 1 E1
Copyright © 2003 Pearson Education, Inc.

22. Output Market Equilibrium in the Short Run: The DD Schedule
Factors that Shift the DD Schedule
Government purchases
Taxes
Investment
Domestic price levels
Foreign price levels
Domestic consumption
Demand shift between foreign and domestic goods
A disturbance that raises (lowers) aggregate demand for domestic output shifts the DD schedule to the right (left).
Copyright © 2003 Pearson Education, Inc.

23. Output Market Equilibrium in the Short Run: The DD Schedule
Figure 16-5: Government Demand and the Position of the DD Schedule
Output, Y
Aggregate demand, D
D = Y
D(E0P*/P, Y – T, I, G2)
Government
spending rises
Aggregate demand curves Y2
D(E0P*/P, Y – T, I, G1) Y1 Y1 Y2
Output, Y
Exchange rate, E
DD1
DD2 E0 1 2
Copyright © 2003 Pearson Education, Inc.

24. Asset Market Equilibrium in the Short Run: The AA Schedule
It shows all combinations of exchange rate and output that are consistent with equilibrium in the domestic money market and the foreign exchange market.
Copyright © 2003 Pearson Education, Inc.

25. Asset Market Equilibrium in the Short Run: The AA Schedule
Output, the Exchange Rate, and Asset Market Equilibrium
We will combine the interest parity condition with the money market to derive the asset market equilibrium in the short-run.
The interest parity condition describing foreign exchange market equilibrium is:
R = R* + (Ee – E)/E
where: Ee is the expected future exchange rate
R is the interest rate on domestic currency deposits
R* is the interest rate on foreign currency deposits
Copyright © 2003 Pearson Education, Inc.

26. Asset Market Equilibrium in the Short Run: The AA Schedule
The R satisfying the interest parity condition must also equate the real domestic money supply to aggregate real money demand:
Ms/P = L(R, Y)
Aggregate real money demand L(R, Y) rises when the interest rate falls because a fall in R makes interest-bearing non money assets less attractive to hold.
Copyright © 2003 Pearson Education, Inc.

27. Asset Market Equilibrium in the Short Run: The AA Schedule
Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Real domestic money holdings
Domestic interest
rate, R
Exchange Rate, E
Foreign
exchange
market R2 E1 1' E2 2'
Domestic-currency
return on foreign-
currency deposits
Money
market 1 R1
L(R, Y1)
Output rises
L(R, Y2)
Real money
supply MS P 2
Copyright © 2003 Pearson Education, Inc.

28. Asset Market Equilibrium in the Short Run: The AA Schedule
For asset markets to remain in equilibrium:
A rise in domestic output must be accompanied by an appreciation of the domestic currency.
A fall in domestic output must be accompanied by a depreciation of the domestic currency.
Copyright © 2003 Pearson Education, Inc.

29. Asset Market Equilibrium in the Short Run: The AA Schedule
Deriving the AA Schedule
It relates exchange rates and output levels that keep the money and foreign exchange markets in equilibrium.
It slopes downward because a rise in output causes a rise in the home interest rate and a domestic currency appreciation.
Copyright © 2003 Pearson Education, Inc.

30. Asset Market Equilibrium in the Short Run: The AA Schedule
Figure 16-7: The AA Schedule
Output, Y
Exchange
Rate, E AA Y1 E1 1 Y2 E2 2
Copyright © 2003 Pearson Education, Inc.

31. Asset Market Equilibrium in the Short Run: The AA Schedule
Factors that Shift the AA Schedule
Domestic money supply
Domestic price level
Expected future exchange rate
Foreign interest rate
Shifts in the aggregate real money demand schedule
Copyright © 2003 Pearson Education, Inc.

32. Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
A short-run equilibrium for the economy as a whole must bring equilibrium simultaneously in the output and asset markets.
That is, it must lie on both DD and AA schedules.
Copyright © 2003 Pearson Education, Inc.

33. Figure 16-8: Short-Run Equilibrium: The Intersection of DD and AA
Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
Figure 16-8: Short-Run Equilibrium: The Intersection of DD and AA
Output, Y
Exchange
Rate, E DD AA Y1 E1 1
Copyright © 2003 Pearson Education, Inc.

34. Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium
Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules Together
Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium
Output, Y
Exchange
Rate, E DD 2 E2 AA 3 E3 Y1 E1 1
Copyright © 2003 Pearson Education, Inc.

35. Temporary Changes in Monetary and Fiscal Policy
Two types of government policy:
Monetary policy
It works through changes in the money supply.
Fiscal policy
It works through changes in government spending or taxes.
Temporary policy shifts are those that the public expects to be reversed in the near future and do not affect the long-run expected exchange rate.
Assume that policy shifts do not influence the foreign interest rate and the foreign price level.
Copyright © 2003 Pearson Education, Inc.

36. Temporary Changes in Monetary and Fiscal Policy
Monetary Policy
An increase in money supply (i.e., expansionary monetary policy) raises the economy’s output.
The increase in money supply creates an excess supply of money, which lowers the home interest rate.
As a result, the domestic currency must depreciate (i.e., home products become cheaper relative to foreign products) and aggregate demand increases.
Copyright © 2003 Pearson Education, Inc.

37. Temporary Changes in Monetary and Fiscal Policy
Figure 16-10: Effects of a Temporary Increase in the Money Supply
Output, Y
Exchange
Rate, E DD
AA2
AA1 Y2 E2 2 1 E1 Y1
Copyright © 2003 Pearson Education, Inc.

38. Temporary Changes in Monetary and Fiscal Policy
An increase in government spending, a cut in taxes, or some combination of the two (i.e, expansionary fiscal policy) raises output.
The increase in output raises the transactions demand for real money holdings, which in turn increases the home interest rate.
As a result, the domestic currency must appreciate.
Copyright © 2003 Pearson Education, Inc.

39. Temporary Changes in Monetary and Fiscal Policy
Figure 16-11: Effects of a Temporary Fiscal Expansion
Output, Y
Exchange
Rate, E
DD1
DD2 AA Y1 E1 1 2 Y2 E2
Copyright © 2003 Pearson Education, Inc.

40. Temporary Changes in Monetary and Fiscal Policy
Policies to Maintain Full Employment
Temporary disturbances that lead to recession can be offset through expansionary monetary or fiscal policies.
Temporary disturbances that lead to overemployment can be offset through contractionary monetary or fiscal policies.
Copyright © 2003 Pearson Education, Inc.

41. Temporary Changes in Monetary and Fiscal Policy
Figure 16-12: Maintaining Full Employment After a Temporary Fall in World Demand for Domestic Products
Output, Y
Exchange
Rate, E
DD2
AA2
DD1
AA1 Yf 3 E3 Y2 E2 2 1 E1
Copyright © 2003 Pearson Education, Inc.

42. Temporary Changes in Monetary and Fiscal Policy
Figure 16-13: Policies to Maintain Full Employment After
a Money-Demand Increase
Output, Y
Exchange
Rate, E
DD1
AA1
DD2
AA2 Yf 1 E1 Y2 E2 2 3 E3
Copyright © 2003 Pearson Education, Inc.

43. Permanent Shifts in Monetary and Fiscal Policy
A permanent policy shift affects not only the current value of the government’s policy instrument but also the long-run exchange rate.
This affects expectations about future exchange rates.
A Permanent Increase in the Money Supply
A permanent increase in the money supply causes the expected future exchange rate to rise proportionally.
As a result, the upward shift in the AA schedule is greater than that caused by an equal, but transitory, increase (compare point 2 with point 3 in Figure 16-14).
Copyright © 2003 Pearson Education, Inc.

44. Permanent Shifts in Monetary and Fiscal Policy
Figure 16-14: Short-Run Effects of a Permanent Increase in the Money Supply
Output, Y
Exchange
Rate, E
DD1
AA2 Yf
AA1 Y2 E2 2 3 1 E1
Copyright © 2003 Pearson Education, Inc.

45. Permanent Shifts in Monetary and Fiscal Policy
Adjustment to a Permanent Increase in the Money Supply
The permanent increase in the money supply raises output above its full-employment level.
As a result, the price level increases to bring the economy back to full employment.
Figure shows the adjustment back to full employment.
Copyright © 2003 Pearson Education, Inc.

46. Permanent Shifts in Monetary and Fiscal Policy
Figure 16-15: Long-Run Adjustment to a Permanent Increase in the Money Supply
Output, Y
Exchange
Rate, E
DD2
AA2 Yf
DD1
AA3
AA1 Y2 E2 2 3 E3 E1 1
Copyright © 2003 Pearson Education, Inc.

47. Permanent Shifts in Monetary and Fiscal Policy
A Permanent Fiscal Expansion
A permanent fiscal expansion changes the long-run expected exchange rate.
If the economy starts at long-run equilibrium, a permanent change in fiscal policy has no effect on output.
It causes an immediate and permanent exchange rate jump that offsets exactly the fiscal policy’s direct effect on aggregate demand.
Copyright © 2003 Pearson Education, Inc.

48. Permanent Shifts in Monetary and Fiscal Policy
Figure 16-16: Effects of a Permanent Fiscal Expansion Changing the Capital Stock
Output, Y
Exchange
Rate, E
DD1
AA1
DD2
AA2 Yf 1 E1 3 2 E2
Copyright © 2003 Pearson Education, Inc.

49. Macroeconomic Policies and the Current Account
XX schedule
It shows combinations of the exchange rate and output at which the CA balance would be equal to some desired level.
It slopes upward because a rise in output encourages spending on imports and thus worsens the current account (if it is not accompanied by a currency depreciation).
It is flatter than DD.
Copyright © 2003 Pearson Education, Inc.

50. Macroeconomic Policies and the Current Account
Monetary expansion causes the CA balance to increase in the short run (point 2 in Figure 16-17).
Expansionary fiscal policy reduces the CA balance.
If it is temporary, the DD schedule shifts to the right (point 3 in Figure 16-17).
If it is permanent, both AA and DD schedules shift (point 4 in Figure 16-17).
Copyright © 2003 Pearson Education, Inc.

51. Macroeconomic Policies and the Current Account
Figure 16-17: How Macroeconomic Policies Affect the Current Account
Output, Y
Exchange
Rate, E DD XX AA 2 Yf E1 1 3 4
Copyright © 2003 Pearson Education, Inc.

52. Gradual Trade Flow Adjustment and Current Account Dynamics
The J-Curve
If imports and exports adjust gradually to real exchange rate changes, the CA may follow a J-curve pattern after a real currency depreciation, first worsening and then improving.
Currency depreciation may have a contractionary initial effect on output, and exchange rate overshooting will be amplified.
It describes the time lag with which a real currency depreciation improves the CA.
Copyright © 2003 Pearson Education, Inc.

53. Gradual Trade Flow Adjustment and Current Account Dynamics
Figure 16-18: The J-Curve
Time
Current account (in
domestic output units)
Long-run
effect of real
depreciation
on the current
account 1 3 2
Real depreciation takes place and J-curve begins
End of J-curve
Copyright © 2003 Pearson Education, Inc.

54. Gradual Trade Flow Adjustment and Current Account Dynamics
Exchange Rate Pass-Through and Inflation
The CA in the DD-AA model has assumed that nominal exchange rate changes cause proportional changes in the real exchange rates in the short run.
Degree of Pass-through
It is the percentage by which import prices rise when the home currency depreciates by 1%.
In the DD-AA model, the degree of pass-through is 1.
Exchange rate pass-through can be incomplete because of international market segmentation.
Currency movements have less-than-proportional effects on the relative prices determining trade volumes.
Copyright © 2003 Pearson Education, Inc.

55. Fixed versus Floating Exchange Rates
In the former model, exchange rates were considered as perfectly flexible.
In reality, exchange rates are managed and rarely in a pure-floating system (Table 17-1 in the textbook).
The central bank can manage exchange rates using its foreign reserves.
Copyright © 2003 Pearson Education, Inc.

56. Fixed Exchange Rates
Monetary Policy Autonomy is lost (triangle), Fiscal policy more efficient.
Symetry:
Ex : USD and the Bretton Woods system, DM and the european ER mechanism
Support foreign shocks
Exchange Rates cannot adjust so there could be persistent misalignments
More investments and international trade
Copyright © 2003 Pearson Education, Inc.

57. Fixed Exchange Rates
Maintaining Fixed Exchange Rates after an Expansionary Fiscal Policy increases the efficiency of the Fiscal Policy
Output, Y
Exchange
Rate, E
DD2
DD1
AA2
AA1 Y2 E1 1 3 2 E2
Copyright © 2003 Pearson Education, Inc.

58. Policy Trilemna for Open Economies
Fixed Exchange Rate
Freedom of capital
movement
Monetary Policy autonomy
Copyright © 2003 Pearson Education, Inc.

59. Floating Exchange Rates
Lack of Discipline (inflation, competitive depreciation…)
More volatility that may dissuade investment and international trade
No speculative pressure, exchange rates as automatic stabilizers (shocks easier to absorb, see the following figure).
Copyright © 2003 Pearson Education, Inc.

60. Floating Exchange Rates
Figure 19-1: Effects of a Fall in Export Demand
Output, Y
Exchange rate, E
(a) Floating
exchange rate
DD2
AA1
DD1 E2 2 Y2 Y1 E1 1
Output, Y
Exchange rate, E
(b) Fixed
exchange rate
DD2
AA1
DD1
AA2 Y3 3 Y1 E1 1
Copyright © 2003 Pearson Education, Inc.

61. Exchange rate crisis The case of the european ER Mechanism
EMS (European Monetary System) fixed parities between european countries currency since 1979
1989 German reunification
1991 Perfect mobility of capital
1992 June, the Danish say « No » to the Maastricht Treaty, and France say « Yes » with only less than 51%
Crisis
Copyright © 2003 Pearson Education, Inc.

62. Exchange Rate Crisis East Asian Crisis
Characteristics of Asian countries : high growth rate, high degree of openess to the world market, low inflation rate, high saving rate but high investment rate (CA deficit).
High profitability of investment opportunities, low uncertainty because of the stability
Copyright © 2003 Pearson Education, Inc.

63. Asian Weaknesses: Starting point:
low productivity growth rate, growth due to a rise in inputs->diminishing returns
Banking regulation: no effective government supervision of banks, excessive lendings (bad loans)
Legal framework concerning bankruptcy
Starting point:
1997, July, 2 devaluation of the Thai Baht
Contagion + economic slowdown of Japan -> East Asian countries could
Rise interest rates
Devaluate (rise in the domestic currency value of the debt)
Copyright © 2003 Pearson Education, Inc.

64. Final Exam The Final Exam covers all the course.
You have to read Mishkin’s textbook p and chapter 22 of the Krugman and Obstfeld’s textbook
2 hours, 6 questions among 7.
Copyright © 2003 Pearson Education, Inc.